When Less Is More: The Benefits Of Limits On Executive Compensation

Peter Cebon

Melbourne Business School, University of Melbourne

Benjamin E. Hermalin

Haas School of Business & Department of Economics, University of California


We derive conditions under which limits on executive compensation can enhance efficiency and benefit shareholders (but not executives). Having its hands tied in the future allows a board of directors to credibly enter into relational contracts with executives that are more efficient than performance-contingent contracts. This has implications for the ideal composition of the board. The analysis also offers insights into the political economy of executive-compensation reform.

When Less Is More: The Benefits Of Limits On Executive Compensation – Introduction

Executive compensation engenders endless controversy. Resentment, rightly or wrongly, about high pay has fueled political action: for instance, “say-on-pay” provisions in the Dodd-Frank law in the US or a recent Swiss referendum on executive pay.1 Although a few scholars have applauded restrictions on executive compensation (see, e.g., Bebchuk, 2007, and Bebchuk and Fried, 2004, 2005), many have opposed them (see, e.g., Bainbridge, 2011, Jensen and Murphy, 1990, Kaplan, 2007, and Larcker et al., 2012). Opposition—or at least suspicion—by economists is not surprising: most economic textbooks caution against limiting prices. Moreover, a large economic literature has made a strong case for freedom of contract (see Hermalin, Katz, and Craswell, 2007, especially §2.2, for a survey).

Yet the literature also acknowledges that restricting private contracts can sometimes enhance welfare (see Hermalin, Katz, and Craswell, §2.3). In particular, parties sometimes benefit by “lashing themselves to the mast”: they can write better contracts today if their options tomorrow are limited. In this paper, we show this logic could extend to executive compensation. To be sure, demonstrating, as we do, that circumstances exist in which restrictions on executive compensation can benefit shareholders and enhance welfare does not prove such restrictions are always beneficial; but it at least indicates that the issue is more complex and less straightforward than textbook-economic intuition might otherwise suggest.

Restrictions can benefit the shareholders—even when they possess all the bargaining power—for the following reason: ideally, as in most agency models,2 the shareholders (or their representatives, the firm’s directors) want to pay executives based on their actions, not those actions’ stochastic outcomes. We assume, however, an informational friction prevents that: although the directors can observe the executives’ actions, that information cannot be verified and, thus, cannot serve as a contractual contingency in a formal contract.3 Yet, because the board of directors plays repeatedly, it may be able to overcome this problem via reputation: the board promises to honor the terms of such an agreement and, even though not legally enforceable, that promise is credible because there is a net loss from reneging; a board that reneges today can’t enter into similar agreements in the future—and thus forfeits the benefits from doing so—because future executives will no longer see such agreements as credible. Such agreements are known as relational or informal contracts (see Malcomson, 2013, for a survey of the literature).

The cost of losing credibility—and hence how deterred the board is from reneging—depends on how good the next-best alternative to informal contracting is. Here, the next-best alternative is a series of future formal contracts in which the executives’ compensation is tied to firm performance, a noisy signal of their actions. The greater the firm’s profits from formal contracts, the greater the board’s temptation to renege on an informal contract. If formal contracting is too attractive, a fully efficient or profit-maximizing relational contract is impossible: the temptation to renege will simply be too great and, because executives would anticipate the board will renege, such a contract fails to provide them incentives. In such a situation, state-imposed restrictions on formal contracts can be beneficial: by making formal contracting less profitable, the temptation to cheat on a relational contract is reduced, which permits the use of better relational contracts.

That it could be infeasible to utilize the optimal relational contract absent state-imposed restrictions helps explain the prevalence of formal incentive (e.g., stock-price-contingent) contracts despite the many criticisms that they are not as effective as desired, or overly reward managers given what they achieve.4 In principle, improvements are possible but unless the board is capable (see Section 6) and can commit, they cannot be realized.5

When Less Is More: The Benefits Of Limits On Executive Compensation

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